When size can spoil the best ideas
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Some experts say it is difficult to run a small, mid cap or best ideas fund when the assets under management have grown too big. The decision whether, or when, to cap is a challenging one.
As funds perform strongly they tend to attract more money, which often means they grow rapidly in terms of assets under management. But becoming a particularly large fund can affect how it is positioned - in terms of number of holdings, for example - and how far up the capitalisation scale it stands.
Some argue that when a fund grows too large it can lose the ability to trade small and medium-sized companies easily. Smaller companies can be relatively illiquid to trade.
A fund can also be forced to own larger companies when its manager would rather not. Alternatively, the assets may have to be spread across many small positions instead of focusing on the manager's best ideas.
It is argued, therefore, that it is difficult to run a small, mid cap or best ideas fund when assets under management grow too big. Some groups and managers do cap their funds, and have done so, but the decision to stop people investing is often a difficult one to make.
Last month the £1.1 billion Axa Framlington Equity Income fund, managed by George Luckraft, re-opened to new investment. In March 2005 it had soft-closed after reaching £700m. Now Luckraft says he is comfortable allowing more inflows. Nonetheless, Axa Framlington has not ruled out closing the fund again in the future.
For Dan Kemp, head of fund research at Williams de Broë, the size of funds is an "incredibly important" consideration. "[But] unfortunately, it is easily missed," he says. "It is not just the size but how the fund has changed over time. If a manager has taken assets rapidly it is important they have a strategy to deal with that."
Kemp tends to look at the size of the companies a fund holds when working out what the maximum size of the fund should be.
"The rule of thumb is we would not want to see a fund that is bigger than the average market cap of the stocks they are investing in," says Kemp. "For example [if the average holding is] £100m, and it is a £1 billion fund, we would be concerned."
The ability to move in and out of investments easily is also important, he says. "[It is] the liquidity principle. How quickly can the manager exit those positions? The effect is it is difficult to run a best ideas portfolio when you're running a large fund.
"It is incredibly important to look at the creep of the number of holdings," he says. "That is diluting the manager's ideas."
However, Kemp says that Neil Woodford's funds "seem to defy all concerns". The Invesco Perpetual High Income fund, launched in 1988 and managed by Woodford, is £8.8 billion as at June 29, while the Income fund, launched in 1979, is £6 billion. Both funds have performed well.
Over five years to June 29 the High Income fund returned 126% compared with an average IMA UK Equity Income return of 87.3%, according to Trust Net. The Income fund returned 125.9% compared with a sector average of 87.3%, over the same period. Woodford has managed the Income fund since 1990 and the High Income fund since 1988.
"[Together the funds] are around £14 billion," says Kemp. "But we've become a little less concerned because Neil has moved his fund(s) higher up the market cap scale. Two years ago he still had a lot of mid cap stocks in his portfolio."
Kemp says the key point is to ensure managers' strategies fit with the size of the fund they are running. A large cap fund could be huge, for example, and not be negatively affected by strong inflows because it can hold large stakes in large companies. Likewise if a fund is set up to carry a large number of holdings, assets can be spread widely, so big inflows are less of a problem.
Like Kemp, Hilary Coghill, director at City Asset Management, says the type of fund is crucial to whether large inflows of money are a cause for concern or not. "If it's a large cap fund it is less of an issue," she says. "[But] small cap funds definitely do need to be capped."
A recent example of a fund becoming exceptionally big is Anthony Bolton's Fidelity Special Situations fund. Instead of capping it, Fidelity split the fund. That decision was made when the fund reached about £6 billion. Bolton himself said it had become too big to manage effectively.
Coghill, however, says she prefers smaller funds overall because, she argues, they have better opportunities to generate returns. "We do favour smaller funds," she says. "It is easier to get in and out of holdings, and with the manager, you often get some of the best performance when they are new and have strong convictions. But there are always exceptions."
Coghill maintains it is "difficult" to deploy large amounts of money and agrees with Kemp that managers have to be suited to running large funds and be good at investing in large cap.
"It's about the strategy and the manager," she says. "George Luckraft was always a good small cap fund manager. [But] it has been more difficult as [his fund] has got so large.
"His performance was better at first. It was tiny when he started and he turned it round."
The Adviser Fund Index series - A Summary
The Adviser Fund Index series comprises an Aggressive, Balanced and Cautious index each tracking the performance of portfolio recommendations from a panel of 19 investment advisers. For each risk profile, all panellists specify a weighted portfolio of up to 10 funds from the authorised UK unit trust and Oeic universe that, when aggregated, define the constituents and weightings of the three AFIs (see www.fundstrategy.co.uk/adviser_fund_index.html).
